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Accounting 9. Capital Budgeting Clive Vlieland-Boddy 2009. Consumption of non Current Assets.

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Consumption of non Current Assets

- Clearly an asset such as an aeroplane lasts for many years. So when American Airlines buys a new plane, it would expect it tl last for say 20 plus years. The cost should therefore be written off over its economic life useful life.
- Here the matching concept requires us to match income with expenditure.
- Remember “prudence”

Capital Budgeting

- Capital Budgeting is a project selection exercise performed by an enterprise.
- Capital budgeting uses the concept of present value to select the projects.
- Capital budgeting uses tools such as pay back period, net present value, internal rate of return, profitability index to select projects.

Capital Budgeting Tools

- Payback Period
- Accounting Rate of Return
- Net Present Value
- Internal Rate of Return
- Profitability Index

Payback Period

- Payback period is the time duration required to recoup the investment committed to a project.
- Business enterprises following payback period use "stipulated payback periods", which act as a standard for screening the project.

Computation Of Payback Period

- When the cash inflows are uniform the formula for payback period is cash outflow divided by annual cash inflow.
- Payback period is the time when cumulative cash inflows are equal to the outflows. i.e.,

Mutually Exclusive Projects

- In the case of two mutually exclusive projects, the one with a lower payback period should be accepted.

Determination Of Stipulated Payback Period

- Stipulated payback period, broadly, depends on the nature of the business/industry with respect to the product, technology used and speed at which technological changes occur, rate of product obsolescence etc.
- Stipulated payback period is, thus, determined by the management's capacity to evaluate the environment vis-à-vis the enterprise's products, markets and distribution channels and identify the ideal-business design and specify the time target.

Advantages Of Payback Period

- It is easy to understand and apply. The concept of recovery is familiar to every decision-maker.
- Business enterprises facing uncertainty - both of product and technology - will benefit by the use of payback period method since the stress in this technique is on early recovery of investment. So enterprises facing technological obsolescence and product obsolescence so that in the electronics/computer industry they prefer the payback period method.
- Liquidity requirement requires earlier cash flows. Hence, enterprises having high liquidity requirement prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recoupment of investment.

Disadvantages Of Payback Period

- The time value of money is ignored. For example, in the case of project A, $500 received at the end of 2nd and 3rd years are given same status.
- Broadly a $ received in the first year and during any other year within the payback period is given same weight. But it is common knowledge that a $ received today has higher value than a $ to be received in future.
- This drawback can be set right by using the discounted payback period method. The discounted payback period method looks at recovery of initial investment after considering the time value of inflows.
- Another important drawback of the payback period method is that it ignores the cash inflows received beyond the payback period. In its emphasis on early recovery, it often rejects projects offering higher total cash inflow.

Further Disadvantages Of Payback Period

- Investment decision is essentially concerned with a comparison of rate of return promised by a project with the cost of acquiring funds required by that project. Payback period is essentially a time concept; it does not consider the rate of return

Accounting Rate Of Return

- Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment.
- The accounting rate of return is based on accounting profits. Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision.
- Accounting rate of return does find a place in business decision making when the returns expected are accounting profits and not merely the cash flows.

Computation Of Accounting Rate Of Return

- The accounting rate of return using total investment.
- or
- Sometimes average rate of return is calculated by using the following

Formula: Net Profit/Average investment

- Where average investment = total investment divided by 2

Mutually Exclusive Projects

- Select the one that offers highest rate of return

Accounting Rate Of Return – Advantages

- It Is Easy To Calculate.
- The Percentage Return Is More Familiar To The Executives.

Accounting Rate Of Return – Disadvantages

- The definition of cash inflows is erroneous; it takes into account profit after tax only. It, therefore, fails to present the true return.
- Definition of investment is ambiguous and fluctuating. The decision could be biased towards a specific project, could use average investment to double the rate of return and thereby multiply the chances of its acceptances.
- Time value of money is not considered

Example

- There are two projects (Project A and B) available for a business enterprise, with a life of 6 years each and requiring a capital outlay of $9000 each and additional working capital of $1000 each. The cash inflows comprise of profit after tax + depreciation + interest (Tax adjusted) for five years and salvage value of $500/- for each project at year 6 plus working capital released also in the 6th year.
- The Profit (after tax) component of the cash inflows for each project are given in the next slide.

Example

Year Project A Project B

1 1,580 280

2 2,080 1,080

3 2,080 1,080

4 80 1,080

5 80 2,580

6 80 1,880

Total Net Profit After Tax 5,980 7,980

Average Annual Net Profit 5,980/6 = 996.6 7,980/6 = 1330

The time value

- Inflation interest rates are significant issues here. If inflation ws10% then any investment that yielded less than 10% would be poor.
- Likewise, interest costs or should we say the cost of capital should be considered. To buy the new plant for $100,000 we will have to find funding!
- Time does have a value and investments should employ tools that take account of this time value.

DCF

The most difficult issue is firstly establishing exactly what the future cash flows are likely to be. Clearly you know what you will have to pay for the new fixed asset, but what cash flows will it generate and what will be its scrap value.

Example:

A company is considering buying a new machine that will cost $100,000 and will generate $15,000 per annum for the next 12 years., then scrapped for $9150.

- On the basics, $100,000 outlay and 12 years at $15,000 plus $9150,($189,150) it would appear as a good investment. But what about the time value of money.
- If I owed each of you $100,000, which would you accept. $100,000 now or £180,000 in 12 years time?

Net Present Value (NPV)

- Net present value of an investment/project is the difference between present value of cash inflows and cash outflows.
- The present values of cash flows are obtained at a discount rate equivalent to the companies cost of capital.

Net Present Value (NPV) – Example

Assuming that the cost of capital is 6% for a project involving a lump sum cash outflow of $8,200 and annual cash inflows of $2,000 for 5 years, the Net Present Value calculations are as follows:

a) Present value of cash outflows $8,200 in year 0 (NOW)

b) Present value of cash inflows

Present value of an annuity of $1 at 6% for 5 years = $4,212 = $8,424

Net present value = present value of cash inflows - present value of cash

Since the net present value of the project is positive ($224),

NET PRESENT VALUE

- This represents the present day value of the cash flows.
- Lets return to our Example of $100,000 purchase of a new machine.
- But first look at the tables on page 702 BMM onwards. We will 8% and 12%

What does this tell us.

- With a cost of capital of 8% the project is good.
- With o cost of capital of 12% it is bad.
- The decision is… a positive Net Present value.

Net Present Value

- This is the total of the discounted cash flows.
- At 8% it was + $16823 and at 12% it was negative by $4735.

Internal Rate Of Return (IRR)

- The internal rate of return method is also known as the yield method. The IRR of a project/investment is defined as the rate of discount at which the present value of cash inflows and present value of cash outflows are equal.
- IRR can be restated as the rate of discount, at which the present value of cash flow (inflows and outflows) associated with a project equal zero.

IRR

- Bar a few cents, the breakeven position where the cash flows discounted to the present value equals 11% cost of capital.
- So the IRR is 11%.

Internal Rate of Return

- This is where the Net Present Value is zero. Ie it it the % rate that discounts the cash flows to a nil value.
- In our case it is somewhere between 8% and 12%. We could re calculate at 11% and say 11.2% and would get to a fair figure.

The Cost of Capital

- Normally this is the WACC.
- A hurdle rate above which projects should be accepted.
- Obviously subject to cash…..

Profitability Index (Pi)

- Profitability ratio is otherwise referred to as the Benefit/Cost ratio. This is an extension of the Net Present Value Method.
- This is a relative valuation index and hence is comparable across different types of projects requiring different quantum of initial investments.
- Profitability index (PI) is the present values of cash inflows and outflows discounted at the rate equivalent to the cost of capital.

Capital Rationing Situation

- Select the projects whose rates of return are higher than the cut-off rate
- Arrange them in the declining order of their rate of return and
- Select projects starting from the top of the list till the capital available is exhausted.

No Capital Rationing Situation

- Select all projects whose rate of return are higher than the cut-off (hurdle) rate.

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